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This article is from the A Guide to Closed-End Funds (CEFs).

Closed-End Funds: Long-Term Factors Influencing Discounts/Premiums

Many funds consistently trade at, close to, or around, a particular level of discount or premium. There may be many factors responsible for determining whether a CEF will trade at a premium or discount, and how much the premium or discount will be. Changes to these factors may cause the discount or premium to adjust to a new stable level.

Ignorance.

Perhaps the most important factor why most CEFs trade at a discount is that CEFs operate in relative obscurity, and hence demand for the shares of the CEFs is low. While most investors have heard about mutual funds, very few have heard about closed-end funds. The reason is obvious: mutual funds advertise extensively to attract investment money, since the management is paid a percentage of the assets managed. However, CEFs, except under very rare circumstances, operate with a stable pool of investment money. Advertising will not increase the asset base; instead, the cost of advertising erodes the assets of the fund.

Performance.

A CEF that consistently underperforms the indices relevant to the fund will eventually trade at a discount as investors leave the fund and fewer investors buy into the fund. Likewise, a CEF that consistently outperforms the indices and related funds will trade at a premium. Examples of funds that have traded consistently at a premium are the Asia Pacific fund and the Templeton Emerging Markets fund [for the bulk of the period between March 1993 to February 1995, the fund has traded consistently at a premium to its NAV, often as high as 30%. One factor that may explain this premium is its strong historical performance record].

Tax Liability.

Many of the older CEFs may have substantial capital gains since shares of companies they bought years ago may be worth a lot more now. New investors who buy such funds may find themselves with a large capital gains tax liability if the funds unwind some of their older profitable positions. For example, if an investor buys shares worth $100, and the next day the fund returns $20 as a capital gains distribution, the investor essentially puts in only $80. Worse still, on the $20 returned to him, he pays taxes (assuming it is a taxable investment), even though he did not own the fund during the time it racked up the substantial gains. So the investor shows a loss immediately. Such funds tend to trade at a discount.

Unique Opportunities.

Some funds tend to trade at premiums because they offer the only vehicle for a particular type of investment that is accessible to individual investors. Many countries do not allow individual investors to participate in their stock markets. In addition, they may restrict the foreign ownership of their companies. Funds that invest in such markets naturally trade at a premium since investors who seek to participate in these markets are forced to buy the shares of these funds. More recently, many countries have started relaxing these restrictions, and their markets are increasingly becoming accessible to individual investors. Examples include the Korea fund and the Indonesia fund. The Korea fund, in particular, has historically traded at sharp premiums.

Risky or Hard-to-Evaluate Portfolios.

Many CEFs invest in private placements, provide venture capital, or invest in companies under bankruptcy re-organization. The valuation of such investments is difficult since no direct measure of the marketability of the shares of these companies is available. In addition, often, such investments are very risky. These funds often tend to trade at a discount. For example, the Equus II fund makes equity and equity-oriented investments in growth capital, leveraged buyouts, or recapitalization of existing companies. Equus II has often traded at discounts of 30% or more.

 

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